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Can California's New Water Desalination Rules Produce a Fountain of Profits?

The California drought is getting worse and worse and now the state is looking to do something radical about it.

California is in a deep drought. It's been focusing on conservation, recently pushing homeowners and even farmers to use less water. But that can't solve the drought, so the state just got more serious about finding additional sources of water. And new rules may be the linchpin to making it happen.

Everyone's doing it!California now has sweeping mandatory water-reduction goals for homes and businesses. It has even gotten concessions from farmers to cut water use by 25% -- and with good reason, because more than 99% of the state is in some form of drought, with a massive 94% or so suffering from severe, extreme, or exceptional drought conditions.

While saving water is clearly important, it only helps on the consumption side. California's big problem is water supply. That's why the state recently introduced new rules around seawater desalination. Essentially, California wants to start using more of the giant water bowl right next to it, but it wants to make sure it gets done responsibly.

The tipping point?This is an interesting fact because there are private companies on the verge of opening up giant desalination plants in the state. There are some 15 plants in total on the drawing board, or under construction. So getting ahead of this water "gold" rush is a good plan for regulators.

But California is also more clearly defining the playing field, and that will make larger players like American Water Company Inc (NYSE: AWK), which owns regional player California American Water, more comfortable putting up funds for such plants. It also raises the regulation bar for competitors that might not have the same ability to meet and adjust to changing rules like an old industry hand with a powerful parent company.

California made up around 8% of American Water's revenues last year, making it a top-five contributor to the top line. Replacing decaying water pipes is the big opportunity for capital spending in the water utility industry. In fact, American Water expects roughly two-thirds of its capital spending to go toward such asset renewal goals between 2015 and 2019.

But roughly 15% of its capital spending is earmarked for "capacity expansion." Desalination plants, like the one its subsidiary California American Water is looking at, would likely fit that bill. This, in turn, would augment the company's ability to push for rate increases, especially in a region that's in dire need of drinking water. And the new rules more clearly outline what such projects should look like, a fact that makes a project easier for American Water to approve.

Out in frontOther players are clearly out in front of desalination, including publicly traded Consolidated Water Co. Ltd. (NASDAQ: CWCO), which is helping to build a desalination plant in Mexico, right across the border from San Diego. However, with more regulation, bigger players could start to see an edge because of their scale and relationships with regulators.

If the idea of solving water access troubles with desalination interests you, don't overlook a smaller player like Consolidated Water. This company derives virtually all of its revenues from desalination, and has operations in the Caribbean and Asia, as well as the plant being constructed in Mexico. It primarily operates in tourist regions, so its business tends to be affected by economic swings. For example, revenues fell more than 20% between 2008 and 2010 because of the impact of the 2007 to 2009 recession.

But if it can get a toehold in California, the company could see further expansion opportunity in the state, where utilities lack its experience in the desalination space. And don't forget that California isn't the only water-starved region in the world, which makes Consolidated a global play on the desalination concept as opposed to American Water, where desalination would augment just one piece of its portfolio.

Regulation can be wonderfulWhen it comes to utilities, regulation can actually be a good thing when it creates barriers to entry for competitors that might try to enter a market. For aggressive investors, California's dire need of water highlights a global water-access issue that a focused desalination play like Consolidated Water can help resolve. More conservative investors, however, shouldn't overlook the benefit that an industry giant like American Water could derive from California's efforts to regulate the space.